April 7, 2016 / 8:12 PM / in 2 years

Canada bond underperformance seen fading as Fed resumes hiking

TORONTO, April 7 (Reuters) - The underperformance by Canadian bonds versus U.S. Treasuries year-to-date is expected to fade as the Federal Reserve cautiously hikes interest rates this year even as Canada’s central bank holds steady, strategists said.

Canadian government bond yields generally remain well below Treasuries. But the differences in yields, or spreads, is narrower than levels seen before the Bank of Canada surprised many traders in January by not cutting rates.

The yield on Canada’s 10-year bond had moved to a record 90 basis points below its U.S. counterpart near the end of last year. The spread moved to 52 basis points on Thursday, the smallest gap since May.

But strategists said this underperformance is nearly finished and some already prefer to own Canadian bonds.

Stronger growth and increasing inflation in the United States will cause the Fed “to hike rates more than is currently priced in,” said Greg Nott, chief investment officer at Russell Investments Canada, a factor he expects to weigh on Treasuries.

At CIBC Capital Markets, head of rates strategy Richard Gilhooly expects Treasuries to underperform as the Fed drives investors into risk assets, such as corporate and high-yield bonds, and actively encourages a rise in inflation expectations.

“(Federal Reserve Chair Janet) Yellen is deliberately falling behind the curve to try to not just foster, but to solidify the gains in inflation that we have seen recently,” Gilhooly said.

He favors the two-year spread in case oil lurches lower, putting the possibility of a Canadian rate cut back in play. He also likes the 30-year spread as he expects Canada’s long end will mostly avoid increased issuance.

Stronger-than-expected Canadian growth, a partial recovery in oil prices and fiscal stimulus have sharply reduced expectations for Bank of Canada rate cuts.

A Reuters poll on Thursday showed forecasters now see rates on hold until the Bank of Canada starts tightening in 2017.

Meanwhile, Yellen surprised markets last week with her cautious stance.

To be sure, a 45 percent spike in 2016-17 bond issuance as the budget deficit climbs to C$29.4 billion ($22.39 billion) is seen as a headwind for Canadian bonds.

“Supply is going to be very abundant, but I think that is now close to fully priced in,” said Jimmy Jean, fixed-income strategist at Desjardins, who also expects Canadian economic data to soften after a solid first quarter.

$1 = 1.3133 Canadian dollars Editing by James Dalgleish

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